ESYJY

Note: Purchasing is possible in Pounds Sterling (GBP) on the London Stock Exchange or on the Over The Counter market in U.S. Dollars (USD). For liquidity purposes, I will be buying in Pounds Sterling on the London Stock Exchange. All figures listed are in Pounds Sterling unless otherwise noted. Current GBP and USD prices as of 2/21/2017 are £9.6 and $48.9, respectively (google finance price is listed in pence). My purchase price was £9.6, but I received a £0.54 dividend on 2/23, pushing my cost basis down to £9.06.

If you want to be a millionaire, start with a billion dollars and launch a new airline. – Sir Richard Branson

EasyJet PLC is a British airline based in London, England. The airline operates, as of year-end FY 2016, 803 routes across Europe and North Africa. As the third-worst performer on the FTSE 100 over the past year, the company’s woes have been compounded by Brexit and the subsequent depreciation of the Pound Sterling. The stock is down 37%, and an American that owned the stock the day before Brexit has seen currency adjusted losses of ~48%. The sell-side expects EPS of £0.77 and £0.89 for the years ending 2017 and 2018, respectively, down from £1.71 and £1.89 a year ago.

CONSUMER AVIATION INDUSTRY

The consumer aviation industry can be separated into two categories: Full-Service Carriers (FSCs) and Low-Cost Carriers (LCCs).

Full-Service Carriers (FSCs)

The Largest FSCs in Europe are Lufthansa and International Airlines Group (post the merger of British Airways and Iberia). American and Delta Airlines are prominent players in the USA. Full-service carriers tend to offer decent customer service, better legroom, first/business class seating options, reclining seats, free snacks, free carry-on luggage, amongst other things. The costs of the aforementioned services are usually incorporated in the ticket prices which makes them expensive. Full-service carriers fly short, medium, long, and ultra-long haul routes using what is called a Hub-and-Spoke network, which pools customers into ‘hub’ city before flying them to their destinations — one who lives at a hub airport is more likely to find direct flights than one who does not. For example, booking a flight from Phoenix to Europe will likely involve being flown to Los Angeles, Dallas, or even New York first before heading off to Europe. Going into Europe, the customers will likely get pooled into Frankfurt, Amsterdam or another hub city before heading off to the final destination.

Low-Cost Carriers (LCCs)

The largest LCCs in Europe are Ryanair and EasyJet. Spirit and Frontier airlines are prominent players in the USA. LCCs tend to exhibit poor customer experience and service: they charge for carry-on luggage, checked luggage, reserving seats, and food and snacks on the airplanes, and also have fewer employees per customer. LCCs have less seat leg room, which enables them to squeeze more passengers into the plane, they have non-reclining seats which are not only cheaper to maintain but also decrease fuel costs because they are lighter. Customers lose out on the aforementioned features but also pay lower airfare prices and have the option and flexibility to utilize and pay for whatever features they choose. LCCs fly short and medium haul routes and use a point-to-point network which is more direct than a central hub.

Advantages of Low-Cost Carriers

Fleet

LCCs tend to utilize a fleet of one or two types of aircraft. This is advantageous because when it comes to training pilots, crew, engineers, and mechanics who fly and maintain the aircraft, it only has to be done for one or two aircraft types rather than multiple. This translates to lower salaries and greater economies of scale from the expensive maintenance equipment and it also increases the feasibility of automation.

EasyJet owns and leases 144 A319s and 108 A320s aircraft. The company recently placed an order for 100 A320neo aircraft (with an option to purchase 100 more), which is not only more fuel efficient but also has more capacity than the A319s and is expected to decrease cost per seat by 13%.

Low Fares/Low Marketing and Advertising costs

LCCs spend less money on marketing and advertising than their FSC counterparts because the fares are cheap and the cheap fares advertise themselves. When customers go online to book flights, they compare prices. The FSCs are forced to differentiate themselves through expensive advertising campaigns that market the value-added features whereas the LCCs spend less on advertising and let the low prices speak for themselves.

Business/First class and no reclining seats

LCCs have higher seat densities than FSCs, they generally do not offer business/first class although they do have some larger seats that cater to customers that are willing to pay more, it is not the forefront of their offerings. Higher seat densities with less leg room which crams more passengers into the plane coupled with fixed operating costs decreases the carrier’s cost per seat. The seats also do not recline, making them not only cheaper to maintain but also lighter, which saves fuel in the process. The lack of first/business class also decreases the number of staff needed per flight.

Higher Aircraft Utilization and Multi-disciplinary Employees

LCCs fly during off-peak hours which translates to lower airport and landing fees. They also have crew members that are multi-disciplinary who clean planes, leading to higher aircraft turn times. The planes are cleaned and maintained at a faster pace than their FSC counterparts primarily because of the simplicity of the aircraft. They also push for online check-ins which decrease the number of additional personnel at the airport, and some LCCs charge customers that choose to physically check-in at airports.

Hub-and-Spoke (H&B) vs. Point-to-Point (P2P)

FSCs use the Hub and Spoke network which pools customers into a hub city before flying them to their destination whereas Point to Point tends to be more direct and the lower number of connecting flights means less baggage, landing, and other airport fees to the carrier and thus, lowers costs. When a flight is delayed, the customers miss their flights and are prioritized for the next available flight with H&B whereas this is less likely to happen with P2P because P2P connecting flights generally have longer layover times which reduces the probability of missing a flight even when it is delayed.

Customers are less receptive to food on the plane, reclining seats, and other features that FSCs offer on short-haul (1-3 hour flights) which is why the LCC model works. Ryanair went as far as floating standing room seats or even charging customers to use the bathroom. The fares are low upfront, but customers make up for it through the various fees it charges. One who does not check-in before getting to the airport has to pay fee of 45 Euros, which is ridiculous given that the average ticket price Ryanair sells is less 50 Euros. Ryanair, without a doubt, is the undisputed king of LCCs so why buy EasyJet? As the old saying goes: you don’t have to outrun the bear to survive, you just have to run faster than the person next to you. Although FSCs now offer some features the LCCs initiated, EasyJet is still sandwiched between the FSCs and Ryanair regarding cost structure and value, and EasyJet also faces temporary headwinds that could improve margins within the next 12 months.

RISKS AND HEADWINDS

Scottish Referendum

Scottish First Minister, Nicola Sturgeon, has threatened the UK with a Scottish referendum on the basis that Scotland voted to remain in the European Union (Scotland voted 62-38 for the remain camp). FM Sturgeon is convinced that exiting the UK and joining the European Union would leave Scotland in a more prosperous position but economic data from the Scottish government contradicts this notion.

Scotland’s 2015 total value of exports was £78.5 billion. Total international exports were £28.7 billion split between exports to the EU of £12.3 billion or 15.7% of the total and exports to non-EU of £16.6 billion or 21.2% of the total. Exports to the ‘Rest of the UK’ was £49.8 billion or 63% of total exports. The numbers above are nominal and not adjusted for inflation, but the trend is clear — exports to the EU, rest of the UK, and Non-EU since 2002 are up 8%, 74%, and 41%, respectively. I am not exactly sure what the economic rationale is for leaving the UK, but it seems that the UK is Scotland’s fastest growing export market, followed by the Non-EU countries, with the EU lagging behind.

One may argue that the way the government counts exports may be distorting the real figures but the disclosures give me confidence:

International Exports

These exports relate to the sale of goods or services to customers overseas. In calculating these figures we look at the final destination of the exports and ensure exports originating in Scotland are allocated to Scotland. For example, a sale by a Scottish company to a customer in France which is shipped via a port in England, would still be classified as a Scottish export to France, rather than a Scottish export to the rest of the UK.

Rest of the UK Exports

These are exports of goods and services by Scottish companies to customers in the rest of the UK. The majority of these exports will be consumed or remain within the rest of the UK, for example electricity or service exports such as financial services. However some of these Scottish exports to the rest of the UK will feed into supply chains elsewhere in the rest of the UK and in turn, underpin the export of subsequent goods and services internationally.

Regardless of whatever reservations one may have about the statistical margin of error in the data, it is clear that Scotland could be potentially making a mistake by prioritizing the EU single market over that of the UK. If Scotland leaves the UK for the EU and a ‘hard-Brexit’ deal is made with tariffs on both ends, it would instantly trigger a Scottish recession. The politicians are downplaying the complexity of such an exit — it would sever not only a political union but also a currency union because scotland uses the Pound Sterling. I believe any knee-jerk depreciation of the pound resulting from a Scot-exit will be short lived.

Brexit Uncertainty

Investors are naturally risk-averse, so the uncertainty arising as a result of Brexit places pressure on the Pound Sterling. Most economists were expecting an immediate post-Brexit recession, but the UK economy fared better than anticipated in 2016 which led both the Bank of England and the IMF to increase their UK economic growth forecasts for 2017. EasyJet’s revenue recognition accounting policies compounded with the uncertainty-led depreciation of the Pound Sterling creates temporary headwinds for EasyJet. Customers book flights months ahead of their desired departure, and the company records revenues when a customer books a flight and records costs when the customer flies. A significant, sharp depreciation in the base currency, GBP, against the USD, which crude oil/jet fuel derivatives, aircraft purchase agreements, and other contracts are negotiated, provisionally elevates costs and depresses operating/net margins. Airplanes run on jet fuel, a derivative of crude oil. If a customer books a flight when GBPUSD trades at $1.48 but the service is provided when the exchange rate is $1.24, EasyJet will receive fewer dollars per pound than the customer initially paid but would still have to purchase a fixed amount of jet fuel.

A rising USD is not necessarily indicative of a depreciating Sterling. If USD continues to rise, as it has over the past two years against other currencies in the world, it will place pressure on commodities priced in U.S. Dollars. The important distinction here is that if the Pound Sterling remains stable, then the artificial increase in jet fuel price increase that was evident last year will not recur. While the GBPUSD is important, an equally or more important metric is the Pound Sterling Index or the Pound Sterling against a basket of currencies.

As of 2016 Q4, 49% of H1 seats have been booked. Continued depreciation of the pound going into 2018 is a risk because it would lead to a recurrence of the current issue. The already depreciated pound and the compelling economic data coming out of the UK should mitigate this problem.

Brexit – Legal and Operations

Britain’s exit from the European Union places regulated industries such as aviation in deep water. The company plans to establish an Air Operator Certificate (AOC) in another EU member state that should secure flying rights to continue doing business within the EU. I do not believe that there is any chance that the EU would bar non-EU companies from operating in within the bloc. Switzerland and Norway are not members of the EU but are part of the Single European Sky initiative so I don’t see why the UK cannot do the same.

Terror Attacks

Terror attacks are unpredictable but present a risk to EasyJet because it decreases travel and tourism activity. There is not much that can be done to mitigate this, but hopefully, we will see less of it in the future than we have in the past.

European Elections

Uncertainty wreaks havoc on markets, and there is no greater risk of uncertainty in Europe than the upcoming elections. With Dutch elections coming up later this month, Geert Wilders is the Anti-EU, Anti-Euro populist candidate that the market is discounting. In France, Marine LePen is expected to win the first round, because there are a lot of candidates and she is expected to take the populist vote which should be enough to propel her to the second round. In round two, however, there are fewer candidates and experts do not expect her to garner enough support to win because the candidate pool will have significantly shrunk. There is also the German election in the fall with Angela Merkel up for re-election.

To put this in perspective, no one expected the leave-camp of Brexit to be successful but they were. No one expected a Trump presidency; the NY Times placed the probability of Donald Trump win over Hillary Clinton at ~20%. Courtesy of the New York Times:

I don’t know whether these candidates will be successful or not but it would be prudent to take them seriously. As one of the healthier eurozone economies, if there is even a sniff of Nexit (Netherlands), a sharp, severe euro depreciation should not be a surprise. EasyJet runs a euro surplus – it takes in more airfare in euros than it has costs – so a euro depreciation will negatively affect its income statement, though not significantly (see Sensitivities – FY17 below). The positive aspect of this is that the company’s debt is also in euros, so a depreciation will devalue the debt on its balance sheet as well, though this won’t show up on the income statement.

CATALYSTS

Defensive Growth

LCCs have structural advantages, as discussed above, over the FSCs on the routes that they jointly inhabit so LCCs will continue to undercut and steal market share from the inefficient FSCs. LCCs also have the advantage of being ‘defensive’ since price conscious customers in recessions are more likely to fly an LCC, hence why they exhibit very consistent profitability even in economic downturns. EasyJet has grown revenue organically at a CAGR of 16% since 2002 but is still fairly attractive under the assumption of zero growth going forward.

Hedge Expiration

LCCs are more likely than FSCs to hedge their future jet fuel costs because it makes up a larger portion of their cost base. This makes it easier for FSCs to compete in a depressed jet fuel market because they are able to shrug off hedging and thus, push down ticket prices to become competitive. Hedging protects one from shocks, however, so while it temporarily depresses income, over the long-term the company is more likely than not to survive if it maintains its conservative hedging program.

As of the end of Q1 2017 (12/31/16), EasyJet hedged 83% and 53% of the rest of its 2017 and its 2018 requirements at the crude oil equivalent of $61 and $51, respectively. Heading into 2018, just over 50% of its expected crude oil input is hedged at a price that is equivalent to market rates. The company lost £300 million and £375 million in 2015 and 2016 from its jet fuel hedges but going forward, EasyJet should be able to maximize the benefits of low fuel prices by passing it on to customers via lower ticket prices or even by even trickling it down to the bottom line. Losses are expected in 2017 but the company expects savings of 240 million when compared to last year, which will be passed on to customers. Hedging issues are short-term and will be abated as EasyJet averages down.

Solid Balance Sheet and Access to Capital

EasyJet closed FY16 with approximately £976 million in cash and £664 million debt. Post the recent dividend in Q1, cash likely still exceeds or approximates debt. The company announced a Euro Medium-Term Note Program to potentially borrow 3 billion euros to fund the expected upgrades from the A319s to the A320 neos. As of 9/30/2016, the company had drawn 500 million euros at a fixed 1.5% for seven years.

On the conservative side, it is my estimate that company will only need to borrow approximately 1.65 billion euros. My assumptions are that EasyJet will generate a flat £600 million from operations (2016 Brexit-depressed CFFO: 600 million, 2015 CFFO: 750 million) and pay the same February 2017 dividend of £215 million going forward. The assumption ignores the ~£760 million cash sitting on its balance sheet and also assumes that CFFO does not grow.

Lower UK Tax Rates

Phillip Hammond, Chancellor of Exchequer, floated the idea of turning Britain into a tax haven. Lower tax rates translate to higher net income and given that the BOE and the British government are pulling all strings to avoid a recession, a corporate tax cut should not be unexpected. Theresa May floated the idea of cutting tax rates lower than any G20 country to encourage business activity in the UK.

VALUATION

EazyJet trades at 11.5x expected 2017 earnings, presenting an 8.7% earnings yield to investors. As the company adjusts prices to reflect the 2016 sterling devaluation, it will recuperate some or all of the FY16 and FY 17 FX losses. Per management’s assertion from the Q1 report, investors should expect £105 million decrease from the £425 million recorded last year as a result of expected FX losses (see Sensitivities – FY17 and GBPUSD 1-Year Chart).

Load factor has been stable even with the increased capacity — the company has not had any problem filling up the plane. A drop in constant currency revenue per seat is expected because jet fuel is a cost input for airfare. Lower jet fuel prices lead to lower costs and thus, lower ticket prices. The highlight of this report is:

Revenue per seat fell 1.2% unadjusted for currency depreciation and 8.2% on a constant currency basis

The Math

The company records revenues when a customer books a flight and records costs when the customer flies so the significant, sharp depreciation of the Pound Sterling between that period becomes the culprit. As the company adjusts prices to reflect this depreciation, it will recuperate some of the FX losses. This should hold true as long as we do not see another depreciation as severe as that of Brexit.

If GBPUSD holds around $1.23, the company will likely recuperate most of the losses. If it falls below $1.23, then the amount recovered will depend on how much it falls. Per the Sensitivity – FY17 table above, if we assume that crude oil remains stable, which is likely because there is still a glut of oil, and we also assume an exchange rate drop of .13 for each currency (Dollar $1.10, Euro 1.03, and Franc 1.11), then the overall gain can be estimated by subtracting £45.5 (Dollar; 13 * 2.4 + Euro; 13 * 0.6+ Francs; 13 * 0.5) from £105 to arrive at £59.5. This assumes that the company does not deviate from the hedging pattern that it has maintained in the past. Because the company adjusts prices, lost income from further devaluations will come out of the potential £105 million and not the expected £320. Today we’re paying 11.8x for a business that faces temporary headwinds with high probability that net income rises next year.

Competitor comparison is difficult in this case because of the variance in the fiscal year ending, hedging, and also the jet-fuel enhanced margins. There are a lot of things that can go right and few things that can go wrong, and an investor today will still receive an 8% forward earnings yield and a >5% dividend yield if all goes wrong. The key here is to watch EasyJet’s hedging strategy, GBPUSD, Pound sterling against an index of other currencies.

Disclosure: EasyJet is 10% of the MaziValue portfolio. I may or may not adjust my my position prior to the Netherlands and French elections, but I will disclose if I do.